Subprime crisis hits governments

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THE SUBPRIME mortgage crisis that pushed homeowners into foreclosure and forced the Federal Reserve to bail out investment banker Bear Stearns has also sent state and local governments across the country scrambling to refinance municipal bonds before they are hit with exorbitant interest rates.
At the center of the storm are long-term variable-interest bonds known as "auction-rate securities." Unlike traditional fixed-rate bonds, the interest rates on these securities are reset every 7, 28 or 35 days through an auction process.

Historically, the rate paid has been less than on traditional bonds, making the national $160-billion auction-rate market a reliable source of cheap financing.

But that market has collapsed in the past two months, sending interest rates climbing. As a result, California, Richmond, the Bay Area Toll Authority, the East Bay Municipal Utility District and Sacramento County are among countless government agencies forced to restructure their bond debts.

For some agencies, the transition will be exceptionally painful if they can't move quickly. For many, the collapse of the auction-rate securities market cost millions of dollars more in interest payments. The public will feel the squeeze through tax increases down the line or less money for much-needed public services and facilities.

That's not to say that issuing auction-rate securities was a bad move by state and local governments. In fact, they have proven very beneficial to

taxpayers over many years. And the government agencies did nothing to cause the market collapse. But the days of cheap money are over for many local governments already strapped for dollars.
After refinancing, Richmond, for example, will be forced to pay about $5 million more during the next two years for interest on about $167 million in bonds issued to fund redevelopment projects and renovate the city center.

The state of California is about to refinance about $400 million in auction-rate securities because rising interest rates have cost taxpayers about $1.5 million extra in the past six weeks. For similar reasons, the state earlier this month refinanced about $500 million in securities that were originally issued to purchase electricity during the energy crisis.

The auction-rate market collapse stems in part from the travails of the insurance companies that promised investors they would cover the principal and interest on the bonds if the government agencies failed to pay. Those insurers are some of the same companies that guaranteed subprime mortgages. When the subprime market imploded, rating agencies downgraded the insurers. That had never happened before. The downgrade, in turn, spooked auction-rate bond buyers because their investments were no longer protected by top-rated insurers.

That sent interest levels on auction-rate securities rising. What had been a cheap alternative to traditional bonds turned into a more-expensive option. In many cases, the auctions "failed," meaning there weren't sufficient bidders to cover the outstanding bonds. Under the terms of the bonds, that triggered a rate increase, which in California could be as high as 15 percent. Elsewhere in the country, the rates can go even higher.

Of the $160 billion auction-rate securities market, there have been about $80 billion of failed auctions over the past month, according to James Goins, Richmond finance director. That city has not had a failed market. But, Goins told the City Council in a March 18 report, the market "has been devastated due to insurer downgrades and lack of liquidity to the point that this market may never come back."

At his urging, city leaders have decided to bail out of auction-rate securities. They expect to refinance their debt by May.

For smaller cities, California Communities, a joint powers authority based in Walnut Creek, is putting together a program to exchange auction-rate bonds for fixed-rate notes. The plan, says program manager James Hamill, is attracting cities, mostly from southern and central California. It will involve the refinancing of an estimated $500 million to $1 billion.

The program will allow cities to join a pool to convert their bonds to one-year obligations. After that time, they will have to restructure again. The bet is that the market will calm down in the meantime. Hamill doesn't expect the cities to return to auction-rate securities.

The Bay Area Toll Authority also has been hard hit by the auction-rate collapse. The agency issues bonds for bridge construction and uses toll revenues to pay them off. The agency has nearly $800 million in outstanding auction-rate securities that it plans to refinance by the end of May.

In the meantime, the authority is paying about $600,000 to $1 million extra interest each month because of the market collapse.

To be sure, some public agencies have emerged almost unscathed. Consider the case of the East Bay Municipal Utility District. The water and sewer agency had about $542 million in outstanding auction-rate bonds at the start of the year, on which it was paying about 3 percent annual interest.

When the market collapsed, the bond rates soared to 9 percent. That cost the district about $3 million in additional interest payments over about two months, according to Finance Director Gary Breaux.

But when the district refinanced its auction-rate debt, it opted for another type of variable rate financing -- one that did not require the agency to carry bond insurance. That was possible because of the district's strong bond rating.

The new bonds are only costing the district about 1.5 percent to 1.8 percent. If those rates stay low, the district might recoup its losses by the end of the year, Breaux says.

The agency benefited by moving fast. To cities and districts facing rapidly rising auction rates, Breaux says, "my advice would be to get out from under it as quickly as you can."